Business Advisor
Straight and Narrow
The IRS will boost audits of small businesses' taxreturns by nearly 40% in 2002. Here's how to play it safe.

Afield audit by the Internal Revenue Service (IRS) is an unnerving experience. Mine occurred in 1982, when a plain brown envelope arrived with a notice from the IRS stating that I'd been selected at random for an audit. We had our first meeting with the agent in charge of my case at my C.P.A.'s office.

First and lasting impression

The agent reviewed my practice income and expenses and zeroed in on the new marketing business (HMI) I was running out of my garage. I guess my replies sounded funny because he stopped the interview and said he'd like to drive over to my house to inspect the marketing operation for himself -- right then.

Fortunately, the audit turned out okay, but the thoroughness of the agent and the surprise nature of his visit to my home are something I still remember.

I'll also never forget the time, the IRS took $10,000 out of my bank account -- without telling me -- to cover payroll taxes that had been paid but posted incorrectly (by them).

A new trend in auditing

Despite my experiences, the IRS has been much less aggressive in the 1990s. Recently released data reveal that less than 1 in 200 individual tax returns was audited over the last 8 years. The dreaded face-to-face audits of high-income professionals have dropped more than 50% since 1992. Many factors, such as budget reductions, lower staff levels and more returns have contributed to the drop.

Down and dirty

Accountants and lawyers are reporting that a huge number of unscrupulous accountants and investment specialists, emboldened by the IRS's lack of diligence, are promoting quite a few aggressive and fraudulent tax evasion schemes to high-income professionals and small business owners.

One questionable scheme shows doctors how to establish offshore trusts to fund them with allegedly tax-deductible dollars. It's designed for doctors to limit their taxable income to what they need to live on despite IRS restrictions to the contrary.

It may catch up with you

Because of the billions of dollars of potential tax revenue involved, these schemes have been placed at the top of the IRS's most wanted list. The Bush administration is increasing the budget to enforce tax compliance, and the IRS plans to shift its focus away from low-income tax payers to high-income individuals. When this is approved, audits of high-income, self-employed individuals (those earning more than $100,000 annually) will increase by 50,000 in each of the next 2 years. That would triple the number of face-to-face audits. Also, the IRS has recently announced plans to boost audits of small businesses' (including optometric practices) tax returns by nearly 40% in 2002 and another 8% in 2003.

As for those flagrant tax evasion schemes, accounting professionals expect the IRS to successfully attack them over the next 3 years and say that participants could really suffer. Case in point, California dentist Dana Gawley reportedly reduced his taxes to near zero in the early 1990s with offshore trusts, only to end up paying more than $432,000 in back taxes, interest and penalties upon being audited a few years ago.

Play it safe

So what should you do? Take advantage of every possible strategy to legally reduce your federal, state and local income taxes. Be wary of aggressive tax reduction plans that look too good to be true. The odds are still good you won't get audited, but if you do, you sure want to have a clean return. 

A frequent writer and speaker on practice management issues, Dr. Hayes is the founder and director of Hayes Consulting. You may call (800) 588-9636 if you need help with your practice.